Tuesday, March 30, 2010

Payback Time : State Debt Woes Grow Too Big to Camouflage

California, New York and other states are showing many of the same signs of debt overload that recently took Greece to the brink — budgets that will not balance, accounting that masks debt, the use of derivatives to plug holes, and armies of retired public workers who are counting on benefits that are proving harder and harder to pay.

Joshua Rauh, an economist at Northwestern University, and Robert Novy-Marx of the University of Chicago, recently recalculated the value of the 50 states’ pension obligations the way the bond markets value debt. They put the number at $5.17 trillion.

After the $1.94 trillion set aside in state pension funds was subtracted, there was a gap of $3.23 trillion — more than three times the amount the states owe their bondholders.

I highly recommend to read the entire NYT link..... Some pretty sobering details how desperate some states are already acting to mask the shortfalls.....

New Hampshire took $110 million from a medical malpractice insurance pool to "balance its budget". The State Supreme Court said put it back.

Colorado tried to grab a $500 million surplus from Pinnacol Assurance, a state workers’ compensation insurer that was privatized in 2002.

Hawaii went to a four-day school week.

Connecticut tried to issue its own accounting rules.

California is making companies pay 70 percent of their 2010 taxes by June 15.

New Jersey and other states make their budgets look balanced by pushing debts into the future. While Greece used a type of foreign-exchange trade to hide debt, the derivatives popular with states and cities have been interest-rate swaps, contracts to hedge against changing rates.

It was only a matter of time. California — following in the footsteps of Ireland and Iceland, Greece, Spain, and politicians of all stripes and nationalities — has called for an examination of credit default swaps sold against its bonds.

California Treasurer Bill Lockyer has sent a letter to six big banks that underwrite the state’s municipal bond sales, asking what the banks’ role may be in also selling credit default swaps on Californian debt

The Muni Market is so far not worried ( surpirse, surprise ) that this house of cards will face any difficulties at least in the near term.........

Investing in municipal bonds is a paradox for investors right now. On one hand, they are attractive because of their tax-free statussince taxes are expected to rise. On the other hand, with the economy as bad as it is, municipalities could come under duress and be at risk of default.

Based on the performance of the National Muni Bond ETF (MUB) in recent months, it looks like investors are weighing the tax advantage more heavily against default risk. As shown below, MUB is up 14.4% from its lows last year, and it is trading near its all-time highs since the ETF was released in 2007.

The chart above is even more "impressive" when you add the following story to the mix.....

March 29 (Bloomberg) — Holders of bonds sold by the Las Vegas Monorail Co. likely won’t get their next payment due July 1 because the insurer, Ambac Financial Group Inc., won’t cover them.

The monorail, linking the city’s casinos, seeks to reorganize under Chapter 11 bankruptcy and has minimal funds to cover its next scheduled debt disbursement of $9.6 million in July, Wells Fargo, the trustee for the bonds, said in a March 26 announcement. While Ambac guarantees payments of $1.2 billion for the monorail, its obligation has been transferred by Wisconsin insurance regulators to a segregated account that temporarily can’t honor claims, according to the filing.

The Las Vegas Monorail example highlights what really matters about the dire state of the bond insurance industry – municipalities, and muni bondholders, are going to get hurt.

The halt marks the first time that a regulator has raised the possibility that Ambac, which insures $256 billion of municipal bonds, may be unable to pay current municipal bond insurance policy claims to preserve reserves for future obligations

The bailout bus keeps rolling. Last week's programs to forgive mortgage principal were good news for mortgage insurers. But PMI Group's share-price surge had an extra lift from Freddie Mac.

The mortgage giant gave a new PMI subsidiary the green light to write insurance for loans that Freddie guarantees. PMI needed the blessing—and got a similar one from Fannie Mae—because its main subsidiary may be banned in some states from writing policies if it breaches regulatory capital rules.

If that happened, PMI's future would be in even greater doubt. The company lost nearly $1.6 billion over the past two years and warned that "as a result of continued losses, we will need to raise significant additional capital and/or achieve significant statutory regulatory relief."

What is curious is that Freddie's and Fannie's support potentially puts taxpayer dollars at risk, while helping PMI shareholders—the company's stock jumped more than 40% last week. The moves also come as debate continues over how much skin in the game homeowners should have.

Help for PMI, and for Mortgage Guaranty Insurance Corp. last month, is also notable because Freddie has suggested that firms like this mightn't be able to meet future claims.

Freddie in its annual filing said "some of our mortgage insurers lack sufficient ability to fully meet all of their expected lifetime claims-paying obligations to us as they emerge." PMI has the lowest credit rating of Freddie's rated mortgage-insurance counterparties.

With the government, through Fannie and Freddie, willing to play such games to keep small fry like PMI and MGIC alive, it shows quite how far away Uncle Sam is from a real solution on "too big to fail."